Islamic Finance, Islamic Home Finance, Diminishing Musharakah.

1. DIMINISHING MUSHARAKAH
By: Camille Paldi
CEO of FAAIF

2. DIMINISHING MUSHARAKAH
 Musharaka in Arabic means “partnership,” so a
diminishing musharaka is a diminishing partnership,
in the sense that a home buyer and his/her bank
are partners in the purchase of the home.
 The diminishing musharaka contract generally
provides for the home buyer to contribute a deposit,
while the bank pays the rest, and the two become
co-owners of the home.

3. DIMINISHING MUSHARAKAH
 The home buyer lives in the house, paying rent to
the bank as well as regular scheduled purchases of
“units” of the bank’s share of the house.
 As the bank’s ownership decreases/diminishes, the
rent decreases accordingly, until the home buyer
has bought out the bank and owns the house
outright.’

4. DIMINISHING MUSHARAKAH
 It is a financing partnership, which diminishes as
the money borrowed by the borrower from the
financier to finance an asset or project is paid back
in installments or other possible arrangements.
 As soon as all the installments on the debt are
completed, the partnership diminishes and the
asset becomes completely owned by the borrower
in the partnership.

5. DIMINISHING MUSHARAKAH
 According to Norton Rose, ‘the financier and the
client co-own the asset in question.
 The portions of ownership at the start of the
financing reflect the financial contributions of each
party.
 Each payment a client makes leads to the
acquisition of a portion of the financier’s share in
the asset.

6. DIMINISHING MUSHARAKAH
 As the client’s share increases, the financier’s
share decreases – hence the term “Diminishing
Musharakah.”

7. DIMINISHING MUSHARAKAH
 This structure is attractive to investors due to the
fact that it is based on the principle of sharing risk.
 The structure is appealing to financiers because it
can incorporate a variable rate of return and has a
credit profile that is acceptable to most credit
committees of conventional institutions.’ (Norton
Rose)

8. DIMINISHING MUSHARAKAH
 Under this contract, the investor, in her periodic
profit distributions to the bank pays over to the bank
not only the bank’s profit share, but also a pre-
determined portion of his own profits, which goes
towards reducing the bank’s capital share.
 This is her profit, which goes towards reducing the
bank’s capital share.

9. DIMINISHING MUSHARAKAH
 The additional funds are either held in an account
to purchase the bank’s share in a lump sum at the
end of the Musharakah period or they are applied
progressively to reduce the bank’s capital share
and thereby also reducing the bank’s claim on
profits.”
 (The Law and Practice of Islamic Banking and
Finance by Dr. Nik Norzrul Thani; Mohamed
Ridza Mohamed Abdullah; and Megat Hizaini
Hassan. (2003))

10. ASSET FINANCE USING DIMINISHING
MUSHARAKAH – NORTON ROSE
 1. The asset is acquired by the financier from a
vendor at cost. The asset is held either by the
financer or by a third party on behalf of the financier
and the client, each of whom retains a shared
interest in the asset.
 2. The client agrees to buy the financier’s interest
in the asset in installments and at cost (in
accordance with a Purchase Undertaking).
 Each time the client buys a share of the financier’s
interest in the asset, the financier’s share in the
asset decreases and the client’s share in the asset
increases.

11. ASSET FINANCE USING DIMINISHING
MUSHARAKAH – NORTON ROSE
 3. At the same time, the financier leases their
beneficial share in the asset to the client. The rent
payable by the client represents the profit due to
the financier. As the financier’s share in the asset
decreases (based on payments by the client under
the Purchase Undertaking), so too will the rent
payable by the client.
 4. After the client has purchased the financier’s
entire share in the asset, title to the asset is
transferred to the client and the lease is terminated.

12. CONSTRUCTION FINANCE USING DIMINISHING
MUSHARAKAH – NORTON ROSE
 The financier and the client each contribute assets
into a pool of Musharakah assets (In accordance
with the Musharakah Agreement). The financier
generally contributes cash and the client
contributes cash and/or assets by way of
contribution-in-kind.
 The client (or a third party) holds the Musharakah
assets as agent on behalf of financier and client
(based on a Management Agreement) with the
objective of the Musharakah (for example, the
construction of the assets or the development of a
site).

13. CONSTRUCTION FINANCE USING DIMINISHING
MUSHARAKAH – NORTON ROSE
 The client agrees to buy the financier’s interest in the
Musharakah asset in installments and at cost (in
accordance with a Purchase Undertaking). Each time
the client buys a share of the financier’s interest in the
Musharakah assets, the financier’s share in the
Musharakah assets decreases and the client’s share in
the Musharakah asset increases.
 The financier leases their share in the Musharakah
assets to the client (in accordance with a lease). The
rent payable by the client represents the profit due to the
financier. As the financier’s share in the Musharakah
assets decreases (following payments by the client
under the Purchase Undertaking) so too will the rent
payable by the client.

14. CONSTRUCTION FINANCE USING DIMINISHING
MUSHARAKAH – NORTON ROSE
 After the client has purchased the financier’s entire
share in the Musharakah assets, title to the assets
is transferred to the client and the lease is
terminated.

15. BANK NEGARA MALAYSIA SHARI’AH
PARAMETERS
 “Musharakah Mutanaqisah (Diminishing
Musharakah) technically is a partnership contract
between two or more parties on a particular asset
or venture, which allows one of the partners to
gradually acquire the shareholding of the other
partner through an agreed redemption method
during the tenure of the contract.
 An IFI may request its customer to give a binding
promise (wa’d) to the IFI to purchase the
Musharakah asset or IFI’s share either on a lump
sum basis or gradually over an agreed period of
time at market value or at a fair value or at any
price to be agreed by the parties.

16. BANK NEGARA MALAYSIA SHARI’AH
PARAMETERS
 The execution of the promise shall not violate the
element of profit- and- loss sharing in the
Musharakah Mutanaqisah contract.
 The transfer of Musharakah asset or share to the
other party in a diminishing Musharakah may be
executed in a single payment or on staggered
basis.
 Transfer of a Musharakah asset may also be made
by way of conditional gift upon the full payment of
the rental obligation.

17. BANK NEGARA MALAYSIA SHARI’AH
PARAMETERS
 In the event of a customer’s default to acquire the
Musharakah asset or IFI’s share, the IFI may
terminate the Musharakah contract and proceed
with a recovery action.
 The IFI may recover its capital from the proceeds of
disposal of the jointly -owned asset to a third party.

18. BANK NEGARA MALAYSIA SHARI’AH
PARAMETERS
 Should the proceeds from the disposal be
insufficient to cover the capital loss, the IFI may
have recourse to the customer for the outstanding
balance. In the case where the customer is
insolvent, the IFI shall bear the loss of capital.
 In the event of a surplus from the disposal of the
proceeds, the surplus shall be distributed between
the partners according to their respective ownership
share.

19. ORIGINATION AND EXECUTION OF
MUSHARAKAH AGREEMENT
 A valid Musharakah contract shall be concluded by
an offer and acceptance between the partners and
may be expressed by way of suitable
documentation.
 A party to a Musharakah contract shall conclude the
contract personally or through an agent.
 A party to a Musharakah contract shall have the
legal capacity to enter into a contract provided that
he is not restricted by any law.

20. ORIGINATION AND EXECUTION OF
MUSHARAKAH AGREEMENT
 Upon the disbursement of the capital by the
Musharakah partners, all partners’ rights to the
profit and liability to losses are established.
 Any term or condition mutually agreed upon, which
does not contravene Sharia’h shall be binding on
the partners.

21. TERMINATION AND DISSOLUTION OF
MUSHARAKAH AGREEMENT
 Partners may mutually agree to terminate the
contract at any time unless stated otherwise in the
Musharakah agreement.
 Upon termination of Musharakah agreement, a
partner may elect to acquire the entire asset of the
Musharakah partnership.

22. TERMINATION AND DISSOLUTION OF
MUSHARAKAH AGREEMENT
 The acquisition by one partner of the other partner’s
entire asset may be satisfied as a debt due to the
other partner, after taking into consideration the
liabilities and determining profit and loss.
 A Musharakah contract shall be terminated upon
expiration of specified tenure of the contract, even
though the venture is still in progress unless the
partners mutually agree to extend the partnership.

23. TERMINATION AND DISSOLUTION OF
MUSHARAKAH AGREEMENT
 Parties to a Musharakah contract may agree to end
the partnership upon completion of business
venture.
 A Musharakah contract may be terminated if a
considerable portion of the capital is impaired,
subject to terms and conditions. Such impairment
may arise from losses due to extenuating
circumstances that hinder the partnership to
continue for the remaining period or from being on
going concern.

24. TERMINATION AND DISSOLUTION OF
MUSHARAKAH AGREEMENT
 The demise or bankruptcy of one of the partners
shall terminate the Musharakah contract. However,
the partners may agree to continue with the
contract according to the terms in the Musharakah
deed or agreement.

25. ILLUSTRATION: CONDITIONS FOR TERMINATION OF
MUSHARAKAH AGREEMENT
 A Musharakah financing agreement between an IFI and
a customer specifies that the agreement is terminated if
any of the following conditions occurs:
 (a) Both partners mutually agree to terminate after
determining the liabilities of each partner;
 (b) Upon demise of the customer;
 (c) Court order to terminate the Musharakah is obtained
by IFI;
 (d) Significant loss of capital that incapacitates the
partnership;
 (e) Insolvency or bankruptcy of the customer; and
 (f) Violation of conditions in the agreement by any
partner.

26. ILLUSTRATION: CONDITIONS FOR TERMINATION OF
MUSHARAKAH AGREEMENT
 In the event that any of these conditions are met,
both partners need to settle any outstanding
liabilities at the date of termination. Upon the
termination of the Musharakah contract,
Musharakah assets shall be subjected to the
liquidation process.

27. LIQUIDATION
 Musharakah assets may be liquidated through actual
liquidation in which the assets are disposed to the
markets or third parties. The proceeds of the disposal
shall then be measured against the capital to recover
the capital and to distribute the profit or to record a loss
accordingly.
 In the case of an actual liquidation, the assets shall be
sold at market value and the proceeds of the sale shall
be used as follows:-
 i. Payment of liquidation expenses;
 ii. Payment of financial liabilities that are owing to the
partnership; and
 iii. Distribution of the remaining assets, if any, among the
partners in proportion to their capital contribution.

28. LIQUIDATION
 A constructive liquidation of the partnership asset
may be effected in the case where the partners
agree to dissolve existing partnership and venture
into another new partnership by investing the initial
asset as capital in kind.

29. AMENDMENT AND VARIATION OF MUSHARAKAH
AGREEMENT
 Amendments and variations to the Musharakah
agreement may take effect at any time throughout
the tenure of the contract on all issues provided
such amendments and variations are mutually
agreed upon by the partners.
 Any amendment to the loss sharing ratio, which
differs from the capital contribution ratio, is not
permissible under all circumstances.

30. AMENDMENT AND VARIATION OF MUSHARAKAH
AGREEMENT
 The Musharakah agreement may provide that any
amendment to the agreement is valid by a specified
approval process such as a majority vote or a
decision by the management.
 The Musharakah contract may enable the partner
to withdraw capital throughout the agreed period
unless stated otherwise in the Musharakah
agreement.

31. THIRD PARTY GUARANTEE OF MUSHARAKAH
CAPITAL
 Specific conditions on third- party guarantee of the
capital are as follows:-
 i. The legal capacity and financial soundness of
such a third -party as a guarantor shall be
independent from the Musharakah contract and
partners;
 ii. The guarantee shall neither be provided in
consideration for nor linked in any manner to the
Musharakah contract;
 iii. The third- party guarantor shall not hold the
majority ownership of the guaranteed party; and
 iv. The guaranteed party shall not hold the majority
ownership of the third party guarantor.”

32. ISLAMIC V CONVENTIONAL MORTGAGE – DR.
MUHAMMAD HANIF (ISLAMIC BANKING THEORY AND
PRACTICE)
 1. Under the conventional financial system, interest
is charged, which is determined on the basis of
demand and supply of the capital. In the Islamic
financial system, rent of the property is charged,
which is determined through demand and supply of
the real asset. Hence, return under conventional
mortgages is not linked with utility creation, while
under Islamic mortgages, the Islamic housing
financial system is linked with the real sector.
Without having a linkage between the financial and
real sector, it is a zero sum game, which does not
add any value to the society as a whole.

33. ISLAMIC V CONVENTIONAL MORTGAGE – DR.
MUHAMMAD HANIF (ISLAMIC BANKING THEORY AND
PRACTICE)
 2. As conventional banks do not own the
underlying asset, there is no sharing of risk and
reward. In relation to Islamic banks, as the bank
and customer are co-owners of the property, they
share risk and reward attached to ownership.
 3. Return for conventional banks starts from the
date of the loan extension facility, which is not the
case for Islamic banks. In terms of Islamic banks,
return is due when the property is ready for use
either through an acquisition or through
construction.

34. ISLAMIC V CONVENTIONAL MORTGAGE – DR.
MUHAMMAD HANIF (ISLAMIC BANKING THEORY AND
PRACTICE)
 4. Return of conventional banks is fixed at interest
while Islamic banks receive rentals as well as share
any appreciation (depreciation).

35. USA HOUSING CRISIS ACCORDING TO DR.
MUHAMMAD HANIF, (PROFIT AND LOSS SHARING)
 It is interesting that Dr. Hanif notes that this concept
may prevent future financial collapses such as seen
in the USA in 2008 with the bundling of mortgages
in collateralized debt obligations (CDO’s).
 Dr. Hanif explains that diminishing musharakah is a
form of declining partnership between the bank and
the customer often used to purchase real estate.

36. USA HOUSING CRISIS ACCORDING TO DR.
MUHAMMAD HANIF, (PROFIT AND LOSS SHARING)
 When the customer requests to the bank for
financing to purchase the asset, the bank
participates in the ownership of the asset by
contributing the required finance.
 A certain portion i.e. 20% must be contributed by
the customer.

37. USA HOUSING CRISIS ACCORDING TO DR.
MUHAMMAD HANIF, (PROFIT AND LOSS SHARING)
 The total equity of the bank is divided into units of
smaller amounts, which are purchased by the
customer in installments.
 Under this mode of finance, the customer promises
to buy the equity units (share) of the bank gradually
until the title to the equity completely transfers to
the customer.

38. USA HOUSING CRISIS ACCORDING TO DR.
MUHAMMAD HANIF, (PROFIT AND LOSS SHARING)
 Dr. Hanif states that the selling of equity shares at
market value by the bank can save the economy
from future collapse.
 He explains that the major reason for the collapse
was voluntary default by the mortgage holders.

39. USA HOUSING CRISIS ACCORDING TO DR.
MUHAMMAD HANIF, (PROFIT AND LOSS SHARING)
 The large number of defaulters reduced the value
of houses.
 The solvent customers of banks realized then that
what they had agreed to pay the banks was much
higher than the declining market prices of houses.

40. USA HOUSING CRISIS ACCORDING TO DR.
MUHAMMAD HANIF, (PROFIT AND LOSS SHARING)
 Therefore, they opted for willful default.
 Dr. Hanif says that ‘had there been diminishing
musharakah in operation, there would have had
been no question of voluntary default as customers
would not be required to pay the par value for the
equity stake of the bank.’

41. USA HOUSING CRISIS ACCORDING TO DR.
MUHAMMAD HANIF, (PROFIT AND LOSS SHARING)
 Dr. Hanif explains that they would have been happy
to pay the reduced amount to the banks according
to the market price of the houses.

43. THE END
THANK YOU!
http://www.faaif.com
Franco-American Alliance for Islamic Finance